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Picking Winners

To get an idea of how quickly the ETF market is growing, consider this: On average, one new exchange traded fund was launched every working day of 2007. Not bad for an industry that, prior to 1993, had zero products in the marketplace.

In all, 270 new exchange traded funds were introduced in 2007, with an additional five launched in the first month of 2008. That brought the total number of ETFs to 634 at the end of January--a 76 percent increase from the end of 2006. Total assets in ETFs at the end of January were $570 billion, up from $421 billion at the end of 2006. And the number of ETF sponsors swelled to 21.

Clearly, ETFs have been a successful growth story on virtually every level, right?

Not so fast.

The growth in the ETF business has been extremely concentrated. Just two ETF managers--Barclays with its iShares brand and State Street with its SPDRs--account for 80 percent of all ETF assets. And the concentration doesn't stop there. At the end of January, 10 exchange traded funds--or less than 2 percent of all ETFs in the marketplace--accounted for roughly 45 percent of all assets.

If your name isn't Barclays, State Street or Vanguard (the third-largest ETF sponsor in terms of assets with more than $41 billion at the end of January), how can you compete in this world? The primary strategy of ETF upstarts has been to focus on niche ETFs based on "designer" indices. As evidence of this tact, the category with the greatest number of new ETFs in 2007 was "specialty," with 141 new funds.

Many of these niche ETFs, however, have gained little traction with investors. Roughly 135 ETFs have less than $10 million in assets, and approximately 300, or close to half of all ETFs, have assets of less than $50 million. Since an ETF probably needs at least $50 million to be considered long-term viable for sponsor and index creator, many ETFs appear to be living on borrowed time.

True, ETF closures have been a rare occurrence. Only one ETF--the SPDR O-Strip ETF--closed in 2006, and there were no closures in 2007.

This year, however, looks to be a different story. Already Claymore Securities has shuttered 11 ETFs:

oClaymore/BIR Leaders 50

oClaymore/BIR Leaders Mid-Cap Value

oClaymore/BIR Leaders Small-Cap Core

oClaymore/Robeco Boston Partners Large-Cap Value

oClaymore/LGA Green

oClaymore/KLD Sudan Free Large-Cap Core

oClaymore/Clear Mid-Cap Growth

oClaymore/Zacks Growth & Income

oClaymore/Index IQ Small-Cap Value

oClaymore/Robeco Developed World Equity

oClaymore/Clear Global Vaccine

The 11 funds closed by Claymore accounted for around 30 percent of the total number of Claymore ETFs. However, assets in the 11 funds totaled less than $35 million, making up less than 2 percent of all Claymore's U.S. ETF assets.

That the ETF industry is seeing some closures is not at all surprising. Certainly the difficult stock market environment of recent months will make it more challenging to grow assets for ETFs that were already struggling to find investor support. Also, with specialist seed money for ETFs becoming increasingly tight, the pressure from specialists to close moribund ETFs is probably growing. Thus, Claymore's move to pull the plug makes perfect sense.

That's why I was a bit puzzled by some of the reaction to the Claymore closings. It seems a number of people were just waiting for such an event so they could play the "I-told-you-so" card. These critics have been decrying the growth of niche ETFs, saying the rapid expansion is wrong for the industry and investors ("C'mon, who really needs a Sudan Free Large Cap Core ETF!"). To these critics, it was just a matter of time before closures would occur en masse.

But also puzzling were the comments of people applauding Claymore's move, suggesting that Claymore acted "responsibly" in pulling the products from the market.

My take is a bit different: Claymore introduced some products into the ETF marketplace, the funds didn't take hold, they offered little hope of becoming economically viable, and so they were axed. It's not a good or bad thing that Claymore brought these products to the market, nor is it a good or bad thing that they folded them. It's simply how the market works.

Thus, from a macro industry standpoint, the 11 closures at Claymore represent a fairly benign event. Indeed, while Claymore closed these 11 ETFs, the firm is planning to introduce a number of new ETFs over the next 12 months.

However, for financial advisors, the closures do highlight an issue that heretofore probably has not been on their radar screen when it comes to ETF investments: What are the client implications of an ETF closure?

To answer this question, let's look at the mechanics of an ETF closure. Claymore announced on February 1 that it would liquidate the 11 funds and that the last day of trading would be February 19. Thus, investors (and financial advisors) had through February 19 to sell their ETF shares on the open market. From February 20 through February 28, shareholders may have been able to sell their shares to certain broker/dealers, but there was no assurance that there would be a market for the funds. Investors still holding ETF shares on February 28 received the value of their shares based on the prices of the underlying securities as of the closing date, including any capital gains and dividends.

What should jump out immediately from this scenario are the potential tax implications of a closure. In this case, the ETF shares were going to cease to exist after February 28, so shareholders were going to realize a taxable event from owning these shares (if, of course, the shares were held in a taxable account) regardless of whether they were sold on the open market or held in the ETF through the liquidation. Given the performance of some of the funds being liquidated, and the fact that 10 of the 11 funds had existed for less than 12 months, the few people who actually owned the shares probably recorded little if any gains and more likely, short-term losses on the sale. Still, the point to remember is that a closure means a forced taxable event, which may muddy up the "tax-friendliness" that helped push you into investing in exchange traded funds in the first place.

The second implication of an ETF closure is that it forces you to reallocate your client positions. If you were drawn to an ETF because of its very narrow niche--for example, your client really wanted large-cap stocks with no exposure to the Sudan--you may find reallocating the assets to a similar ETF a bit challenging.

One thing that ETF closures will not do is have a negative impact on the price of the ETF shares prior to the liquidation. This seems counter-intuitive. After all, when it comes to stocks, wholesale dumping of shares (which probably occurred with the Claymore ETFs prior to liquidation) would drive the stock's price down sharply. However, although ETFs trade like stocks, they aren't stocks. They are baskets of stocks that trade based on the prices of the underlying securities. And while I suppose big selling of a particular ETF may cause some minor dislocations in the price of the ETF versus the net asset value, those dislocations should be quickly arbitraged away. The bottom line is that forced selling of an ETF as a result of a pending closure should not impact the market price of the ETF.

Another misconception about ETFs is that the size of bid-ask spreads is driven primarily by the ETF's asset size and trading volume. Thus, wholesale dumping of tiny, thinly-traded ETFs--perhaps as a result of a pending closure--should negatively affect the bid-ask spreads. Again, an ETF is not a stock. Spreads on stocks are established based primarily on the availability and trading volume of the stock. Stocks with modest trading volume tend to sport high bid-ask spreads. In the case of an ETF, the spread is established based primarily on the tradability of the underlying securities in the ETF--not on the asset level and trading volume of the ETF itself.

For example, the SPDR DJ Wilshire Large Cap (ELR) ETF has less than $10 million in assets and average daily trading volume of less than 6,000 shares. Yet, because it focuses on large, highly liquid securities, the average bid-ask spread is fairly modest.

Still, it is probably best to avoid ETFs that you presume to be on their deathbed, no matter how interesting or attractive the market niche might be. A big reason is that an ETF closure will generate one of those painful "conversations" with your clients. You'll be stuck explaining the intricacies of ETF construction and taxation. Good luck explaining that to your clients--not to mention trying to answer that embarrassing question of why you chose an ETF for them that nobody else wanted. And who needs those discussions!

So, what are the symptoms of a terminal ETF? Low assets (you can check asset levels at the Web sites of ETF sponsors), modest daily trading volume, and mediocre performance. The last factor is especially important. A fund sponsor will be more apt to keep alive an "orphan" ETF that is performing well. The thinking is that as this ETF develops a good long-term track record, ETF rating services will recognize the fund, and assets will eventually follow. However, a fund with a poor performance and few assets is not likely to survive for very long, even if it has an attractive or unique market niche.

The table on page 53 lists a number of ETFs with assets under $10 million, modest average trading volume, and double-digit losses since inception. For these funds, the hearse may be rounding the corner.

Chuck Carlson, CFA, is chief executive officer of Horizon Investment Services and the author of Winning With The Dow's Losers (HarperBusiness). David Wright, CFA, provided research assistance for this article.

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